Optimality, Rational Expectations and Time Inconsistency Applied to Inflation Targeting Strategy

The purpose of this paper is to analyse the characteristics of an inflation targeting strategy, using the Barro-Gordon model specific tools. This paper uses the initial Barro-Gordon concepts of inflationary social costs and benefits, adding a new dimension generated by the cost of output deviating from the potential level. The main contribution of this paper is the exhaustive study of the time inconsistency problem generated by the very existence of a policymaker-established inflation rate. The mathematic simulation of a model allowed a complete analysis of several parameters’ influence (parameters such as the optimal rate of inflation, the discount rate, the importance structure of inflationary social cost) on the applicable range of the target inflation rate, range that guarantees that the policymakers have no incentive to break their own rules, or at least this incentive is somewhat inferior to the future cost of doing so.